Iron Miners Look Surprisingly Brittle

A sharp drop in market prices below breakeven levels is melting the outlook for once-strong names in this once-strong sector, and we'll have to wait a bit to see if a rebound is coming, writes MoneyShow's Jim Jubak, also ofJubak's Picks.

The drop in the price of iron ore—down to a new three-year low on August 30 of $90.75 a metric ton delivered in China—has sent the share prices of iron-ore miners tumbling. Brazil’s Vale (VALE), for example, was down 38.96% for the year as of the close on August 31.

But the real damage—the company-threatening damage—isn’t being administered to the big dogs in the sector. Those big mining companies may see earnings devastated and revenues slashed, but they have the balance sheets and the access to credit that will let them ride out this plunge in prices.

It’s the highly leveraged, frequently smaller and newer players that are at risk. For them, the damage isn’t just in a lower share price, but in a need to sell assets and/or slash development plans in order to keep the company afloat until better times arrive.

You’ll find the greatest pain in China and Australia. The breakeven level for Chinese iron ore miners, mining equipment maker Joy Global (JOY) calculates, is about $120 a ton. At the current price near $90, these companies are bleeding losses. The 40% drop in the price of iron ore in the last four months has been especially brutal because it has been so quick.

Those miners with good connections in Beijing will be able to borrow from China’s big state-owned banks to ride out the bottom of the cycle. Less well-connected companies will be forced to sell off inventory at any price and, counter-intuitively perhaps, to increase production because even running at a loss produces cash flow that can be used to keep creditors from the door.

Look for signs that, despite the drop in iron ore prices, iron ore production in China might actually increase—forcing down prices even more—over the next few months.

Fortescue Metals Group (FSUMF in New York or FMG.AU in Sydney), Australia’s third largest iron-ore miner and by far its youngest, might well wish it had a deep-pocketed government-controlled bank or two to tap for a loan. Citigroup estimates that the company needs an iron ore price of $105 a ton to service the debt it has taken on to develop its mines and transportation infrastructure. The company is the biggest seller of junk-rated bonds in the mining sector.

And on August 29, Moody’s Investors Service announced that it had put its Ba3 rating for Fortescue under review because of the 24% drop in iron-ore prices in the last month. A drop from Ba3, Moody’s third-highest credit rating for junk bonds, would affect $7.6 billion in Fortescue debt.

Fortescue’s current capital spending plan calls for the company to invest $10.6 billion to expand mines, expand a port, and extend rail lines in Australia’s Pilbara iron-ore region. The company has said that it is considering selling assets such as power stations to raise cash.

When the company reported annual results on August 24, it said that it felt that iron-ore prices would pick up in the seasonally stronger September to November period, and that production (and cash flow) will increase when the Christmas Creek expansion goes online in September.

The company’s debt facilities should be enough to get the company to somewhere in 2013 (depending on the price of iron ore), according to Credit Suisse.

I can’t see the stock climbing much from its August 31 close of $3.60 until investors see the company’s debt picture stabilize. And that depends on the trajectory of China’s economy. I’d look for a bounce on the share price in the fall on higher production and seasonally stronger prices.

To know whether that bounce will simply mark a good time to sell and cut losses, or signal the beginning of a recovery in iron-ore prices (in which case Fortescue would be one of the best stocks to own to profit from that turn), just hope that economic data out of China in October or so gives a better indication of future trends there than current data.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did not own shares of Fortescue Metals or Vale as of the end of March. For a full list of the stocks in the fund as of the end of March, see the fund’s portfolio here.